John Authers

Quite a few people seem to dislike a column I wrote earlier this week on exchange-traded funds and their role in the emerging market sell-off. So let me offer a little extra data that was not in the earlier piece.

The following chart, compiled from Strategic Insight Simfund data, shows total inflows and outflows from US investors to emerging market equity funds of three types: active funds, indexed open-ended funds, and indexed ETFs. Figures are in billions of dollars. Starting in 2009, when emerging markets began their rebound, and going through to the final quarter of last year, I believe the story it tells could not be much clearer: ETF money is flighty.

Money in ETFs is far more volatile and far more prone to exit in a hurry than money invested in emerging markets through other vehicles. As EM investing is supposed to be a game for the long term, this is a problem. Read more

John Authers

How exactly should we benchmark hedge funds? It is obviously unfair to compare them directly to equity indices, as the whole point of hedge funds is to aim for an “absolute” return, not a return relative to gains in the equity market. They will naturally under-perform an S&P 500 tracker in years like 2013 when the stock market shoots straight up.

I drew attention last week to the way hedge fund returns have been left badly behind by long-only equity returns over the five years of the post-crisis relief rally, and this understandably provoked comments that this was an unfair comparison. There are also obviously many methodological problems with creating hedge fund indices. Hedge funds have many different strategies, and they may be particularly prone to “survivorship bias” – those that do not have a good story to tell tend to shut down quietly, and do not tell index compilers about their record.

However, hedge funds do have to accept that their offerings will be used by asset allocators trying to use them to balance against the main asset classes of equities and bonds. On that basis, the following chart, produced by Barclays’ capital solutions group using HFRI indices, is very interesting.

It confirms a basic intuition: hedge funds did very well during the bursting of the dotcom bubble, more than held their own during the subsequent 2002-2007 rally, and have had a far harder time of it in the last five years. Why might this be? Read more

John Authers

The Bank of England has hit the target at last. UK inflation is at 2 per cent, bang in line with the Bank’s target, for the first time since the end of 2009. This is good news for the UK, which had been buffeted by an incipient inflation problem. But it is part of a global trend that could be far more problematic: deflationary pressure.

As the chart shows, the BoE now completes a set of all the four major developed market banks – along with the Federal Reserve, the Bank of Japan and the European Central Bank – to have inflation at or below the target of 2 per cent. Read more

John Authers

At first, the idea that the Nobel economics prize should be shared between Eugene Fama and Robert Shiller sounds absurd – akin to making Keynes and Friedman share the award.

Gene Fama, of the University of Chicago, is famous as the father of the Efficient Markets Hypothesis, after all, while Yale’s Bob Shiller is famous primarily for being the principal critic of that hypothesis. Read more

John Authers

Russell Napier’s Anatomy of the Bear seems to be quite a cult classic among investors.Anatomy of the Bear I regularly see it on portfolio managers’ desks. Meanwhile, his video interviews with the FT in the years since the crisis also seem to have created quite a cult following. This week he completed his fourth interview with us since 1999, and he is sticking to his claim, based on historical experience, that the S&P 500 will need to slide down below 500 once more before this bear market is over (he did say 400 in the book).

How much has his story changed, and how seriously should we take him? This obviously divides opinion. So here are his previous interviews with us, in chronological order. Read more

John Authers

Just what depths of political stupidity are markets discounting? The partial shutdown of the US government passed with little or no impact on the markets that stood to be most affected, even though there was uncertainty about it to the end.

Almost all European stock markets opened higher, despite the news from the US. The dollar index dropped 0.35 per cent in the minutes following the realisation that the shutdown would happen, and then recovered somewhat. The yield on the benchmark 10-year Treasury bond gained 5 basis points to 2.66 per cent – still far below the 3 per cent it briefly touched a few weeks ago. So what has happened so far – the failure to agree on a budget and an initial shutdown of the US government – has evidently been priced in. Read more

John Authers

We all now know that the Federal Reserve opted not to “taper” last week. In other words, it kept its monthly purchases of bonds at $85bn without reduction, in a move that was a surprise to many, even if the FT had made clear for a while that a taper was no foregone conclusion.

But have others been tapering already? The official Treasury Department data show that foreigners have this year started very gently selling down their positions of Treasuries. This is the chart:

The move is not great, but it is there. To be precise, foreign holdings of Treasuries reached $5.72tn in March, and by the end of July were at $5.59tn. This is no great change in itself, but it is changes at the margin that matter – and we already know that a “taper” or otherwise in the Fed’s bond purchases was able to generate a dramatic market reaction. So what is going on? Read more

John Authers

Lehman has, at last, been bankrupt for five years. I posted the last of the five-video series we put together for the anniversary here. This post is for those hardy few who have still not had enough of Lehman memorabilia. If you have the time and inclination, try looking through some of these videos, which I made at the time (when I was based in New York and still covered the Short View).

First, this video, which we produced for what we then considered to be the first anniversary of the crisis, in August 2008 a few weeks before Lehman, bears re-watching. The key message to be derived from it is that claims that nobody saw the Lehman bankruptcy coming, or the crisis that surrounded it, do not hold water. It features today’s interviewee, the former Olympic fencer James Melcher, and his comments are particularly prescient: Read more

John Authers

The Lehman bankruptcy was five years ago, as you may have noticed. Five years on, it is surprising what aspects of the pre-Lehman landscape have survived, and which have vanished. This came out in today’s Note video with Larry McDonald, author of A Colossal Failure of Common Sense, and a Lehman alumnus:

Lehman Legacy

Note that while the recovery in the financial system has been in many ways remarkable, the securitisation market remains as dead as a dodo. These charts tell the story. First, here are the figures for asset-backed securities:

So there is a recovery in auto loans, but securitisation of home equity loans, by which Americans turned their homes into ATMs, seems to have ended. Next we can look at CDO issuance (not for the squeamish): Read more

John Authers

Maybe we should reinstate Glass-Steagall. Or maybe we should revisit the system of publicly quoted banks. That at least seems to be the implication of comments made to me by John Reed, who spent almost two decades as the CEO of the old Citicorp and then joint CEO of the newly formed Citigroup. You can find text from my interview with him here and here.

However, I think it is worth highlighting still another passage, as it cuts to the heart of how banks should be valued, and arguably even how they should be owned. He now believes that commercial banking and trading cultures should not be combined. When I pointed out that trading can boost returns, he made the following response:

I could understand that an institution might want to bridge both businesses. If someone like Deutsche Bank were to be only a commercial bank it would be a quite different entity. They’ve used that investment bank to change their earnings profile and their ROE [return on equity] targets. They have a 20 per cent target for ROE.* You could not achieve that in Europe with a commercial bank. You have to get heavily into the markets to imagine getting those kinds of returns.

I think the industry would be healthier if instead of looking at returns they look at p/e [price to earnings] ratios. The more you become a trading organistion, the less your p/e. You should aspire to be like Coca-Cola and have a 20 times p/e.

Obviously the numbers are approximate, and the figures for Deutsche need to be updated. To be more precise, Deutsche under its former CEO Josef Ackermann had a 25 per cent “pre-tax ROE”, which our banking editor Patrick Jenkins suggests would be more like 16 or 17 per cent under German taxes. At present, Deutsche’s ROE, which varies considerably from quarter to quarter, is more like 12 per cent. But the validity of Mr Reed’s point is unaffected, as is clear from this chart. Coke is the blue line here (note Citi’s price/earnings ratio went almost to infinity as it was seen returning from loss to low earnings in 2010). Aside from the rude interruption of the great financial crisis, the point stands that the market will pay a much higher multiple for the earnings of a consumer branded company that it will pay for the earnings of a universal bank.

Banks v Coke

Note: Citi high PE reflected negative and then v low earnings

There then comes the issue of whether Glass-Steagall or something like it should be reinstated, forcing commercial banks to divest their trading arms. Banks have lobbied fiercely against this. Mr Reed suggests that this is against the public interest: Read more

John Authers

This is a public service announcement on Tobin’s q. Following my On Monday column, there were several requests for charts. Here, then, is a chart produced by Andrew Smithers showing how Tobin’s q and the Robert Shiller cyclically adjusted price/earnings ratio vary with respect to their own mean over time:

 Read more

John Authers

Can CAPE guide us around the world? One reasonable complaint during the last week’s debate on cyclically adjusted price/earnings multiples is that the discussion is too US-centric. There are reasons for this. The US is still by far the world’s biggest stock market, the data are more reliable and go back further, and most of the academic players in the debate are based in the US. But it is still a reasonable complaint.

Here then are the results of the exercise in using multiples of 10-year rolling average earnings to value a range of world markets, as carried out by Mebane Faber of Cambria Investment Management, who kindly gave me his data. One huge caveat is that the data do not go as far back as for the US (although this at least means that we do not need to have arguments about whether it is possible to make comparisons with earnings from the late 19th century). The Faber data for the UK go back to 1927; none of the others go back further than 1969; and for some of the emerging markets the data only go back to the 1990s. The full details can be found on this post, and Mr Faber provided me with updated results to the end of July this year. Read more

John Authers

We all know that reported earnings are manipulated. But are they manipulated any more than they used to be, and are they manipulated so as to overstate profits, or understate them? And is the manipulation now so extreme that it is no longer relevant to compare profits over long periods of time? That is where the debate over CAPE (the cyclically adjusted price/earnings ratio) has reached. Even if it sounds technical, it is of vital importance when trying to work out whether the market is undervalued – as much of the stock broker community likes to argue – or in fact overvalue.

For those who missed them, the FT recently published my latest Long View column, defending the cyclically adjusted price/earnings ratio as calculated by Robert Shiller of Yale University and its relevance, quickly followed by a Market Insight column from Jeremy Siegel of the University of Pennsylvania’s Wharton School, and author of Stocks for the Long Run, arguing that Cape’s “overly pessimistic predictions are based on biased earnings data”. An academic conference on the subject is coming up in September.

Some navigation might be helpful. This is not just an arid academic dispute but a matter of critical interest to practising investors. As discussed last week, CAPE has been an impressive metric of value for over a century, and it sticks out from other metrics at present by signalling that stocks are badly overvalued (by 63 per cent for non-financials according to Andrew Smithers, a firm advocate of CAPEs as defined by Prof Shiller). Various different exchange-traded funds are now available that attempt to time switches between sectors based on their CAPE ratios.

However, the fact that CAPE is so bearish makes it unpopular. So does the undeniable fact that CAPE has been too bearish to be of great use to the average asset allocators over the last decade, failing to signal that stocks were cheap before two separate rallies, both of which saw stocks double over a period of four years. (You can see charts of CAPE over time in earlier LongShort posts here and here). Proponents of CAPE would counter that the measure is not for tactical asset allocation and that valuations cannot be used for timing the market.

So bulls are now trying to show either that Shiller’s CAPE was always flawed, or something has happened in the last decade or so to make the measure less useful. The academic participants know a lot of money is riding on this. Much more after the break. Read more

John Authers

One of the biggest areas of controversy over CAPEs or cyclically adjusted price/earnings multiples (see this earlier post and the huge correspondence it provoked) concerns exactly how earnings are measured, and how they can be compared over time. Neither is a unique problem for CAPE compared with other valuation metrics, but they can still change conclusions over the vital topic of whether the US stock market is now overpriced.

There is action on this front in the academic world, with Jeremy Siegel of the Wharton School proposing that an alternative measure of earnings should be used. This might change conclusions, and there will be more on that next week. For now, I would like to introduce another fascinating attempt to alter the methodology of Yale’s Robert Shiller, who has been central to popularising the CAPE over the last two decades.

Back in 2009, Alain Bokobza of Societe General released the results of his own new normalised CAPE, and his colleagues have kindly updated his data. The essential new insight was that corporate taxation has not been constant over the years. Rather, it was introduced in 1911 at only 1.5 per cent. After the First World War it rose to 15 per cent, and then, as the apparatus of the welfare state rolled out over the ensuing decades, it rose to 40 per cent. Mr Bokobza contends that this affects the multiple that investors will pay. So he recalculated the CAPE for the years before 1950, assuming a 40 per cent tax rate.

To give a quick example; If you pay $100 for $10 of earnings untaxed, you have paid a p/e of 10. If it is taxed at 40 per cent, you have paid a multiple a little above 16 on post-tax earnings. This comparison may more accurately, according to Mr Bokobza, help build a norm for what investors are prepared to pay for the earnings they buy. Without making such an adjustment, Mr Bokobza contends, we are effectively comparing post-tax earnings post-war with what can almost be called pre-tax earnings pre-war. This is a contentious point of view; throughout the period, taxation was a given for investors. Many other factors were also changing. But it makes a case that pre-war multiples may not be directly comparable to post-war ones, and suggests an intuitive fix. (And indeed the comparability of earnings is the subject of growing academic debate, and is very relevant when trying to get a handle on long-run valuations). A look at how this changes the historical picture comes after the break. Read more

John Authers

Cyclically-adjusted price/earnings multiples (CAPEs), as made famous by Yale’s Professor Robert Shiller, are growing inconvenient for the brokerage community.

Last week, BofA Merrill Lynch’s Savita Subramanian pointed out that of 15 popular measures of equity valuation, CAPE (which compares share prices to a 10-year moving average of real earnings) was the only one that made stocks look expensive. The list of valuations suggesting US stocks are either cheap or at fair value includes:

  • trailing p/e
  • forward consensus p/e
  • trailing normalised p/e
  • price/book
  • enterprise value/ebitda
  • forward PEG (p/e ratio divided by growth)
  • trailing PEG
  • price/operating cash flow
  • price/free cash flow
  • enterprise value/sales
  • market-based equity risk premium
  • normalised equity risk premium
  • S&P 500 in WTI oil terms
  • and S&P 500 in gold terms

CAPE is thus beginning to stick out like a sore thumb. As it has been showing that stocks are expensive throughout most of the current rally, there is now a widening attempt to discredit or ignore it. Merrill’s own complaint is typical:

The Shiller P/E, which is based on inflation-adjusted earnings over the past 10 years, currently suggests that stocks are overvalued. However, this metric
assumes that the normalized (cyclically-adjusted) EPS for the S&P 500 is today less than $70—well below even our recessionary scenario for EPS. The
methodology assumes that the last 10 years is a representative sample, but the most recent profits recession was the worst we have seen and was exacerbated by a high leverage ratio which has since been dramatically reduced. Assuming that this scenario is going to repeat itself is, we think, overly pessimistic

But is it? Earnings volatility has certainly been extreme over the last decade, and arguably unprecedented. But if anything that suggests that the measure – which grew famous from efforts to predict the bursting of the dotcom bubble in 2000 and to show that the 2003-07 bull market was a “fools rally” – is more, not less, useful. That is the contention of Prof Shiller himself, and it is a reasonable one. More on this, with charts, and some comments from Prof Shiller, after the break. Read more

John Authers

Let’s try to drill into the global picture for earnings, following on from Monday’s column. The picture is undeniably unexciting, but we need to take two divisions into account. First, financials have followed a different logic from the rest of the corporate sector over the last five years or so, for obvious reasons. Second, US companies have profited far more than companies elsewhere in the world, for reasons that are far less clear.

Let’s start by looking at the global picture, with and without the financials. Earnings per share for the MSCI indices (with thanks to Andrew Lapthorne of SocGen for providing this data) look like this: Read more

John Authers

Ben Bernanke can move markets, and sometimes his words are too strong for his own good. That may have been true of his press conference last month, when he announced that he planned to start tapering off QE bond purchases later this year, and end them altogether by next summer. That drove a dramatic rise in Treasury yields, and in the dollar.

For a further classic example, look at the speed with which currency markets responded late on Wednesday and early on Thursday to a speech he made in Massachusetts, and to the minutes from last month’s meeting of the Federal Open Market Committee, published on Wednesday. The euro gained 4.5 cents against the dollar in a matter of minutes, while the pound gained almost 4 cents (or about 2.6 per cent). Read more

John Authers

The fun part of the eurozone crisis, if there is one, is that you never know where to look. After the Cyprus crisis three months ago, the hunt was on for the next small peripheral country that would create a headache. Slovenia was a popular bet. So, among some hedge fund managers, was the Netherlands, where house prices are dropping alarmingly. There was a frisson of concern about Croatia’s accession to the EU. But it turns out that the next country to administer a shock, two years on from its bail-out, is Portugal.

You do not need to be an expert in Portuguese politics to see that the country is in a crisis, or that local markets were shocked by developments. When the foreign minister hands in a resignation hours after the finance minister has done the same thing, over an issue of core economic policy, and the existence of a fragile coalition is called into question, then it is natural that prices will be revised. Read more

John Authers

One of the biggest arguments for emerging markets during their bull market, which started in 2003, was about “decoupling”. The idea was that the emerging markets had now managed to decouple from the developed world, and would be impervious to a recession there. It never worked as it was supposed to, with the arguable exception of a few hectic months at the end of 2008 when China’s stimulus appeared to end. Now, I’d argue, the decoupling has ended, but not in a good way.

I discussed emerging markets with Barclays’ Larry Kantor in a Note video. That included the following chart, which shows that emerging markets have now underperformed the developed world over the last five years, a period that starts roughly with the crisis over Fannie Mae and Freddie Mac in the hot summer of 2008:


Significant EM underperformance when developed markets were performing well is a new experience for many currently operating in the markets. More detail (and charts) after the break. Read more